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External Financing and Adjustment

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1991
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The challenge in designing a viable adjustment program

Marcelo Selowsky

For many developing countries facing economic stagnation and heavy debt burdens, the foremost challenge is to recover sustainable growth. That means finding the right combination of domestic policies and external finance to: (1) reduce macroeconomic instability, reflected in high inflation and high and volatile real domestic interest rates; (2) restore growth while allowing a minimum increase in consumption per capita so that the adjustment can be sustained; and (3) reduce the external debt burden, which restricts voluntary external financing and acts as a tax on investment.

These objectives, however, cannot be achieved overnight, and there are some significant trade-offs among them—trade-offs that change as time passes. This means that an adjustment program must be viewed in an intertemporal context, relating actions and outcomes over time. Most important, the role that external finance plays in the adjustment program must be identified, as higher levels of financing, particularly at the early stages, are often a feature of these programs.

External financing potentially increases a country’s investment rate (potentially, because that financing might end up in higher consumption or capital flight). It also enables more imports of capital goods and inputs and a better utilization of capacity. But some day this financing must be repaid, and when this occurs, it will be at the expense of lower levels of expenditures and a lower availability of foreign exchange. A careful analysis is thus necessary to assure that the benefits of foreign borrowing today are larger than the cost of repaying it in the future. This is all the more important in cases where a country is already highly indebted.

In examining the relevant trade-offs, the intertemporal analysis becomes crucial. Recovering growth requires higher levels of investments and imports, requirements that can be moderated if the efficiency of resource use also increases (reflected by a lower incremental capital-output ratio, ICOR). But for investment to increase, additional external financing is needed to complement domestic savings, unless consumption is further compressed. However, a gradual reduction in the debt burden (as measured by debt/GDP, interest/GDP, etc.) requires a decline in the need for new external borrowing relative to GDP—and this can only be achieved if there is a reduction in the excess of the country’s total expenditures over its income, namely a reduction in the country’s current account deficit relative to GDP. This necessitates an increase in domestic saving relative to the country’s investment and a corresponding increase in its exports relative to its imports. Normally the country must generate both a saving surplus and a corresponding export surplus.

How then do we balance the potentially positive effect of additional external borrowing with its adverse effect on debt accumulation? How do we make compatible the required increase in the trade and saving surpluses with the higher levels of imports and investment required to recover and then sustain growth? How do we reduce the need for domestic financing of the public sector deficit—as needed to lower inflation and the crowding out of the private sector—if the government has to service large interest payments? The analysis must be able to show how a temporary acceleration of external financing allows breathing time, so that the improved policies eventually permit the economy to recover stability and growth together with a gradually declining current account deficit as a percentage of GDP. This article presents a framework—essentially three mechanisms—through which external financing plays just such a role during the transition.

External and internal adjustment

To recover output and then growth, countries must raise the levels of imports and investment, but to reduce the external debt burden, they must increase their export and saving surplus. Both conditions can be achieved simultaneously only by expanding exports and domestic savings. It takes time, however, for exports to expand—even under the best of policies—and the growth of domestic savings is constrained by the need to maintain consumption levels in the short run.

Foreign saving can finance such a resource gap during the transition. But this can be justified only if this support is accompanied by policy measures that gradually reduce the need for further external financing. Exports must expand and import substitution must be made more efficient. To this end, reform of the trade regime is crucial (e.g., unifying the exchange rate and replacing quantitative restrictions with low and uniform import tariffs).

In many countries, generating a saving surplus—an excess of domestic saving over investment—has proved to be harder than generating a trade surplus—the excess of exports over imports. However, this higher saving surplus cannot come at the expense of the investment necessary to recover growth, in particular, private investment. Foreign financing can temporarily fill the gap between investment requirements plus external interest payments and the domestic savings rate, while the latter is given a chance to increase. But this means the adjustment program must include reforms to increase domestic savings, such as financial deregulation and the elimination of directed credit, mandatory reserves, and interest ceilings. Reducing macroeconomic instability is equally important for encouraging savings and the desire to invest. This calls for a fiscal adjustment, a crucial area to which we now turn.

For a fuller discussion, see “The Debt Problem and Growth,” by Marcelo Selowsky and Herman G. van der Tak, World Development, September 1986.

Fiscal adjustment

When the public sector holds a large amount of external debt, it must raise the resources required to service the debt—that is, it has to solve its “own” internal adjustment problem. In addition to external borrowing, it can tap the central bank and domestic capital markets. But this generates further macroeconomic conflicts and trade-offs: high inflation and high real interest rates stunting private investment.

To be compatible with the adjustment program, the public sector accounts must incorporate: (1) a critical level of public investment necessary to complement private investment in the recovery of growth; (2) tax reforms that do not create new distortions; (3) reduced borrowings from domestic capital markets to avoid crowding out private investment; (4) a level of inflationary financing compatible with a moderate inflation rate—one that does not generate uncertainty and misallocation of resources; and (5) a time profile of refinancing of external interest compatible with an eventual reduction of the external burden. This is a difficult agenda.

How then can external financing assist the fiscal adjustment? First, increases in public saving must be achieved by efficiently raising tax revenues and cutting government consumption that cannot be defended on efficiency or equity grounds. To be permanent and avoid reversals, such measures require deep institutional reforms. Second, domestic financing of the deficit must be cut quickly, so as to stop crowding out the private sector and reduce the inflationary pressures stemming from borrowing from the central bank.

But it takes time to increase public saving efficiently, while the need to cut domestic financing is urgent. It is here where external financing plays a critical bridging role by allowing progress made in fiscal saving to be translated immediately into lower domestic financing of the deficit. As public saving rises further, foreign financing can be gradually reduced to avoid an unsustainable buildup of external debt. In managing this process, there is a trade-off between the crowding out and inflationary effects of domestic financing, and the future burden of external interest payments arising from foreign financing.

Improvements in efficiency

The success of an adjustment program hinges crucially on reforms aimed at improving the efficiency of resource use and the productivity of investment. These permit a higher growth rate out of the same level of investment and imports. Many of the reforms discussed earlier have such effects. Trade reforms move resources into sectors that generate or save foreign exchange more efficiently. Financial sector reforms and the elimination of regulations that prevent entry into specific sectors and activities allow resources to move where the productivity of capital is higher. Removing quantitative allocations and licenses moves resources previously devoted to “rent seeking” (seeking income from privileged access to controlled services or goods) into true productive activities. Lowering inflation enhances the informational content of prices, thereby improving resource allocation. The same is true of reforms that raise the productivity of public investment; prestige or national security arguments for inefficient public investments can no longer be justified.

External financing can help by allowing a better redistribution of the gains and losses of these reforms among members of society and over time. For example, decontrol of agriculture or food prices to improve producer incentives might generate strong adverse reactions among urban consumers, but these might be counteracted quickly by targeted food programs supported by external financing. Privatization or restructuring of inefficient public enterprises might require significant layoffs of personnel, along with significant compensation payments and retraining programs.

Graphical exposition

Another way to look at these delicate adjustment issues is by visualizing the manner in which external financing and domestic policies interact over time. Chart 1 shows the adjustment required to eventually lower the ratio of external interest payments to GDP while maintaining a minimum growth of output and consumption. This calls for a reduction in the ratio of the current account deficit to GDP and a slower growth of debt than of GDP.

The analysis starts by specifying a growth rate of output—in this case, 5 percent per year—that can be achieved given the past history of the country and given a restoration of investment and import levels, as well as an improvement in the efficiency of resource use. Next, the investment requirements as a fraction of GDP are set, in light of the efficiency of resource use (the ICOR), keeping in mind that this level can always be lowered if domestic policies improve. On top of these requirements, there is the need to make interest payments on the external debt. The sum of the investment requirements and external interest payments is shown as the “resource requirement” line, and the difference between this line and domestic savings is the current account deficit (shown as the dotted area).

In order for the current account deficit/GDP to decline, the economy has to generate a critical level of saving surplus and a matching export surplus. For a given investment level, the saving surplus will increase only if the saving rate goes up. For this to happen though, consumption has to grow at a slower pace than GDP, but sufficiently high to allow for some growth in per capita consumption. On the other hand, because GDP growth requires a minimum growth of imports, exports will probably have to grow faster than GDP.

We have here a razor-edge problem: If consumption and output growth are set too high, the current account deficit may become too large to permit a movement toward a lower interest payments/GDP ratio. But if GDP growth is set too low, it will be difficult to achieve an increase in the domestic saving rate while simultaneously achieving some predetermined growth in per capita consumption.

The complications do not end there. Chart 1 also shows that a situation might arise where a country cannot reduce the current account/GDP ratio and simultaneously sustain a minimum GDP growth. This could result for a number of reasons: the initial conditions may be too severe (e.g., too high an initial debt/GDP ratio, savings cannot increase because the country has been in recession for too many years and per capita incomes are too low), or the adjustment might be extremely sensitive to movements in exports prices or world interest rates. The dotted upper extension of the “resource requirement” line shows a situation of the latter type. Under these circumstances, a reduction in the stock of debt or interest payments relief would be necessary to allow the current account/GDP ratio to move eventually to a lower and sustainable level (as evident in the right-hand side of the chart).

In addition, there might be situations in which the country could markedly improve its performance.Chart 1 assumes a constant ICOR (i.e., a constant relationship between growth and the investment rate), but we would expect improved policies to change that relationship as time passes, allowing for a faster growth given a fixed level of investment.

To better understand the fiscal adjustment needed to achieve the outcome depicted inChart 1, it is helpful to look atChart 2, a close replica ofChart 1, but with one important difference: the public sector can also borrow domestically. The objective now is not only to reduce external borrowing but to reduce domestic borrowing and to do so more quickly. This is essential if the economy is to be stabilized and the crowding out of private investment is to be stopped.

External and internal adjustment with a “5%” GDP growth

chart 1.The external and internal adjustment

Chart 2.Adjustment in the public sector

Chart 2 shows the public investment rate necessary to achieve the 5 percent growth plus the levels of external and domestic interest payments that have to be served—the “resource requirement line.” To finance it, the government generates a surplus of revenues minus consumption (excluding interest payments). As long as those resource requirements are higher than that surplus, the public sector has a deficit (the overall shaded area) that is financed by borrowing externally and domestically.

The adjustment shown aims at quickly eliminating (by year T*) all public sector domestic borrowing. For that purpose, government revenues must increase sharply and government consumption must be reduced quickly, using external borrowing to finance the “transition”—that is, all progress in public saving is translated into lower domestic borrowing. This transitional role of external financing allows the public sector to increase its saving efficiently, particularly if this calls for institutional changes requiring time.

We can see in these charts a number of the critical trade-offs and links between the debt problem, deficit financing, and stabilization. Cutting external financing too quickly in order to reduce the growth of debt means that a higher share of the deficit must be financed from domestic sources. The resulting inflation and low private investment will stunt growth and the possibility of servicing debt. At the same time, however, too much reliance on external financing can make the growth of debt explosive. The adjustment must be designed so that foreign financing complements the stabilization program and is consistent with a decline in the debt/GDP ratio. It can provide countries the necessary time to reduce their budget deficit to levels that can be sustained and to rely less on foreign financing.

Conclusion

This analysis highlights the strong complementarities between domestic reforms and external financing in the adjustment process. Sound domestic reforms without sufficient external financing may jeopardize the adjustment process by unduly reducing consumption levels in the short run, and thereby undermining the political sustainability of the program. On the other hand, external financing without sufficiently strong domestic reform would simply add to debt accumulation without enhancing the long-run growth prospects of the country.

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